A new report from Greenwich Associates has identified several trends suggesting hedge funds are moving out of the "alternative" realm and into the mainstream.

The report suggests that institutional investment in hedge funds is transforming what began as a niche category catering mainly to high net worth individuals and US endowments and foundations into a permanent fixture within institutional portfolios.

Gross institutional allocations to hedge funds throughout the world have yet to break free of a narrow range surrounding 1% of total portfolio assets. However, as global institutional investors implement strategies aimed at shoring up and maintaining solvency ratios, and opportunities in other alternatives like private equity remain capacity constrained, an increasing number are incorporating hedge funds for their potential to deliver incremental returns, portfolio diversification, and other perceived benefits.

"Although their initial appeal might have been the promise of home-run returns, hedge funds are maturing into a mainstream institutional investment product or asset-class,' said Greenwich Associates consultant Chris McNickle, "A cadre of firmly established hedge fund managers has the potential to evolve into something of a second-generation asset-management industry."

In Japan, the percentage of institutional investors using hedge funds more than doubled from 18% in 2003 to nearly 40% in 2004. Among European institutions, the proportion using hedge funds jumped to 32% in 2004 from 23% a year earlier. For US institutions, 23% used hedge funds in 2003 and preliminary data from Greenwich's 2004 research indicates that usage for this year has reached 28%.

This exponential expansion suggests that the growing number and influence of hedge funds could itself have an impact on future performance levels. Hedge fund returns were disappointing through the first three-quarters of 2004 - a performance that could be a simple reflection of changing conditions and decreasing market volatility, but could also be suggestive of a more secular shift. Institutional rate-of-return expectations for hedge funds over the next five years range from 9.1% in the United States to 5.6% in Japan. Average actuarial rate-of-return assumptions declined from 2003 to 2004 in the United States (from 8.6% to 8.3%) and Japan (from 4.7% to 4.2%), while increasing in Canada (7.1% to 7.4%), the United Kingdom (6.1% to 6.5%), and continental Europe (6.1% to 6.2%).

As hedge funds proliferate and accumulate capital, they are making up a larger portion of trade flows in a variety of markets. For example, hedge funds this year made up 82% of trade volume in US distressed debt and almost 30% of volume in US below-investment grade bonds and credit derivatives. In fact, hedge funds accounted for more than half of the listed or vanilla OTC options contracts and almost a third of the total number of futures contracts traded in the United States in 2004. In exchange traded funds, hedge funds accounted for more than 70% of US trade volume.

"The half-life of opportunity in any of these markets is short," says McNickle. "As hedge funds generate a larger portion of overall trading volume, they are wearing down arbitrage opportunities in some strategies. However, even if returns are moderate, Greenwich believes that hedge funds will remain a permanent part of institutional portfolios."

Other trends identified in the report include:

Professionalization - Hedge funds are "professionalizing" in order to meet the transparency, servicing, and other requirements of large institutional investors. They are also diversifying their strategies and adding long-only options that appeal to many institutions. At the same time, the line between so-called "traditional" investment management firms and hedge fund managers is blurring as established asset-management organizations add hedge funds to their own product offerings.

Regulation - The cost of compliance with new US Securities and Exchange Commission rules will weed out some smaller hedge funds by increasing the barriers to entry and the perceived break-even threshold for hedge fund assets.

Return Moderation - Hedge fund returns appear to be moderating, at least for now. As more money flows into the sector and hedge funds proliferate, arbitrage opportunities are diminishing. The consultants at Greenwich Associates view it as unlikely that hedge funds as a broad-based industry of hundreds of billions of dollars will be able to replicate the robust returns generated by a relatively small number of funds in recent years.

Talent Migration - As some of the brightest minds in investing continue to migrate to hedge funds from traditional asset managers, institutions may already see hedge funds as a high-priced mechanism for accessing alpha generation opportunities and the top talent in the industry.